Edward Chancellor, author of the seminal book on financial speculation and manias “Devil Take The Hindmost,” is now turning his eyes to China. He sees a number of red flags which point to excess in China.

Chancellor writes:

In the aftermath of the credit crunch, the outlook for most developed economies appears pretty bleak. Households need to deleverage. Western governments will have to tighten their purse strings. Faced with such grim prospects at home, many investors are turning their attention toward China. It’s easy to see why they are excited. China combines size – 1.3 billion inhabitants – with tremendous growth prospects. Current income per capita is roughly one-tenth of U.S. levels. The People’s Republic also has a great track record. Over the past thirty years, China’s Gross Domestic Product has increased sixteen-fold.

So what’s the catch? The trouble is that China today exhibits many of the characteristics of great speculative manias. The aim of this paper is to describe the common features of some of the great historical bubbles and outline China’s current vulnerability.

Everyone knows there is extreme levels of excess. The latest report from Andy Xie on local governments shows that governments are now depending on asset prices for revenue, much as they did in places like California during America’s housing bubble.

How can we identify a speculative mania? Chancellor says:

bubbles can be identified ex ante, as the economists like to say. There also exists an interesting, if rather neglected, body of research on leading indicators of financial distress. A few years ago, many of these indicators were pointing to rising economic vulnerability in the United States and other parts of the globe. Today, those red flags are flying around Wall Street’s current darling, The People’s Republic of China.

That’s because Beijing was vigilant in preventing asset and credit bubbles from spilling over into the real side of the Chinese economy. This was very different from the Japan endgame of the late 1980s, where the confluence of equity and property bubbles led to a massive overhang of excess capacity.

Roach’s confidence sounds an awful lot like blind faith in the Chinese authorities to me – exactly the opposite of what Roach’s former colleague Andy Xie is saying.

Chancellor includes this blind faith in the 10 signposts of manias and financial crises (very reminiscent of Kindelberger, by the way).

"A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear."

"Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward."

"Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. Irresponsibility is condoned."

See Stephen Roach’s comments again. Check.

"A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious."

About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com

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60 comments

Funny. The US is 10 for 10 as well. Perhaps we need a bit more introspection and a little less finger pointing. China, for all their malinvestments and bubbles, at least have a new (read not rusted out) manufacturing base and a gleaming new infrastructure. We have a service economy (Yeah, THAT was a great idea) and a 100 year old dilapidated infrastructure. Sorry, but China still beats the US in the next few decades. Oh, and they execute bankers whose banks fail over there: Not advising that we do that, but it sure means that they have a sounder grasp of moral hazard than we do.

That would include servicing the technology, which allows most to avoid true physical toil & drudgery, right?
And developing the existing tech further, and the continuous innovation in processes by degrees, is “service”, too.

No over-simplification or over-generalization there. Does flipping burgers = brains or making computer chips = only dummies need apply?

The problem with our supposed service economy is that we’ve increasingly abandoned manufacturing but forgotten that goods are easier to export/import than services. Hence while we have a trade surplus in services it’s small compared to the deficit in goods.

Bill, you are definitely on to something! Of course the US has misallocated resources – and still is doing so. Chancellor (and Grantham) can get away with pointing fingers because they are both British and do not work in officialdom.

But, I respect the fact that they are taking a firm position on this just as GMO did during the Nasdaq bubble and the housing bubble after it. Perhaps, people will heed them this time rather than re-allocating their money out of GMO as they did previously.

I don’t think that Chancellor (who, incidentally, wrote a great book called “Devil take the Hindmost”) was necessarily “finger pointing”. I think he was just trying to point out that from a potential investor’s perspective, the optimism regarding the Chinese market has gotten ahead of itself.

Nor is he alone in that view–Chanos, for example, has been saying the same thing for over a year now.

I think it’s already widely accepted that the US was 10 for 10 and may even, at present, still be much the same way, having learned nothing from the recent bust. That doesn’t take away from the writer’s points and it’s not about “finger pointing” at all. The fact is, if China does end up with a huge, burst economic bubble, it will mean further devastating news for the world economy and recovery. That’s the point here. It’s not about blame at all.

Exactly. A Chinese bubble is a terrible thing even for Americans and other people outside of China. I’m a big proponent of balancing our trade, but a Chinese bubble actually makes that harder and the potential consequences worse.

The US does not have a dilipidated infrastructure; we have a world-class infrastructure that can deliver anything, anywhere within a moment’s notice. China’s infrastructure is in its infant stages. Leave the major metroplitan areas and you get dirt roads.

Re executing bankers: I’m all for it; we have a lot in this country that deserve it, but don’t confuse the Chinese government’s justice with actual justice. Bankers and officials only get executed if they have displeased their political masters or been on the losing end of a political fight.

Jeff, I think you missed the point. Mal-Investment is poorly/unprofitable focused investment. Yes, China has build some great social infrastructure during this bubble (heck the US has a great fiber structure from the DOT COM bubble), but something like 70% of their economy is export dependent and that dependecy is built upon a falsely valued currency. If that isn’t mal-investment then I don’t know what is.

I don’t know what U.S. you live in. Mine has municipal water systems that leak multiple millions of gallons of water every day, sewer system built in the 19th century, bridges that collapse, and an interstate highway system that is decades old, and crumbling streets in major cities.

Get real. A real stimulus plan would address these needs, instead of giving useless tax breaks.

Yes the Austrian school suggests that all bubbles collapse (how original), but what they ignore is how that bubble came into being (via unregulated OTC derivatives) and its potential geo-political consequences (social unrest, leading up to possibly something more ominous a la Teabaggers/Neo-confederates).

How to get a $295m loan from a Chinese bank:
1. Be a local government investment vehicle, or own one.
2. Say you will use the loan for a high-profile investment.
3. Proceed to use the money for something else.

Don’t make it more complicated than it is. There are really only three major players in the global market. To wit: Who’s going to buy China’s exports besides the U.S. consumer? Will Germany? Hah. Will China’s own? Hah.

Chancellor has another book titled Capital Account which is likely the best investment book out there. Now that GMO has Jeremy Grantham, Edward Chancellor and James Montier, GMO has by far the best investment and economics papers available on the web. BTW, James Grant has been saying the same regarding China

The rain-dance of those waiting for collapse here continues. But they’re comparing Chinese apples to American oranges. If a sustained growth rate of 8% plus were to occur in any western country it would accurately be termed a bubble, ergo if the same occurs in China, it must be a bubble. Or inaccurate statistics. Or corruption. But the view on the ground here in the Tianjin-Beijing corridor requires a corrective. There is an obvious mania in the property market and a spate of overbuilding. Just look out the window or take the train, you don’t need a Ph.D. On the other hand the investment in new manufacturing plant is visible everywhere as are improvements in public transport, roads, bridges, freight, and air travel. Consumer prices and particularly food staples aren’t moving much; wages are easily outpacing price rises for everything except housing. The 2 trillion in reserves will easily cover local government follies, there’s a reserve army of 600 million peasants who will migrate to urban centers, be accommodated in reasonable conditions, and who will thank the bosses while they work for low wages that are still higher than what they’d get growing rice. If there is a bubble it is the folly of a thousand firms who are investing directly in new plant, plus the real investable surpluses at the disposal of the Chinese government. Ergo, the “bubble” if it is anything, is a temporary bulge in productive investment, excessive only in comparison to the ability of the developed world to absorb such production. What a folly!

Mandarin said, “The 2 trillion in reserves will easily cover local government follies.”

According to Michael Pettis this is not true, “As long as China maintains its own currency and denominates all domestic transactions in RMB, the PBoC reserves cannot be used in China. They cannot go to pay doctors’ salaries, to build bridges, to lower taxes or to subsidize consumption. They can only be used to purchase or pay for things from outside China.”

The $2 trillion in reserves is used as collateral to back RMB denominated bonds, and can be used as a last resort to cover wasted local expenditure. There are other expedients to deal with this problem the most obvious of which is limiting future lending and when necessary rolling over the debt. The problem is not new in China and is a now a matter of degree, not of kind. Some governments may be in trouble but most of these are in less developed areas where the locals have gotten dizzy with success – likely not the major productive centers. If Mississippi were to become involvent, it wouldn’t take the entire US down with it.

”
8% plus were to occur in any western country it would accurately be termed a bubble, ergo if the same occurs in China, it must be a bubble. Or inaccurate statistics. Or corruption. But the view on the ground here in the Tianjin-Beijing
”

Would you guess that large part of Chinese Economy is dependent on US Financial Underpinnings, but large part of US Economy now lives in China? When effort to prop up US Financial Underpinnings inevitably fails will Germany pass free markets on into the future as farWestern fades and farEastern regresses? Would these ideas make Germanic appear more attractive for today’s investment dollar? Where you are finding more bang for the ¥.

I agree with Chancellor but agree too as some have pointed out here that this has been known for many months. The Chinese have blown a succession of bubbles, loans, commodities, housing, stocks, and production overhang. It has been clear for a very long time now that the Chinese government has been flailing and flubbing its response to the global crisis. The Chinese leadership is just as wrongheaded in its approaches as the Germans, the British, or us. There are no smart or clearsighted people in positions of power who can pull this thing out or show others what needs to be done. That is the tragedy of our times. The solutions are there. We talk about some of them here and elsewhere everyday. But we aren’t the ones with the power, and the ones who have it aren’t listening, out of hubris, greed, and because real solutions would mean an end to business as usual, and they are far too addicted to the way things are, even as it falls apart.

Thank you for the comment. For me, solutions are workable ways of dealing with problems. I don’t think the policies we have seen from Bush, and now Obama, fit that definition. They have pursued a course of extend and pretend. The core problems remain unfixed and unaddressed. They have not so much prevented a blowup as delayed it. This would make sense or at least be defensible if they used this breathing space to reset and restructure our financial system. Instead the plan seems to be to recapitalize the banking sector by hitting ordinary Americans twice. Once as taxpayers with the government buying up bad debt from banks at inflated prices and financing new rounds of speculation out of Fed and government backed credit lines, and again by letting banks gouge customers. Neither of these is involved in real wealth production. The result is that funds are flowing from other parts of our economy into not only the least productive but the most wealth-destroying sectors of it. So currently we aren’t solving or managing our problems.

The further we go without meaningful action, the more painful and radical the solutions are going to have to be. It’s like a cancer. Catch it early a simple excision may be all that required. Let it go until it’s Stage IV and the treatment, if there is any, are almost worse than the disease. So there will be pain at this point, and more later if we do not act. The question we should be asking is pain for whom, and how can it be most fairly and equitably be distributed.

I had to address Mandarin. It is always easy to put a happy face on the upside of a bubble. I am sure many Americans looked out their windows 2004-2006 and saw all those new homes going up and thought, This is Progress! And in 2007 and early 2008, I am sure that those who felt that, if they saw any problem at all, as the wheels were coming off, dismissed any warning signs as a “temporary bulge,” no more, nothing to get worried about.

But tell me what is China going to do when US consumers stop buying? How will that production overhang help you then? What will the Chinese government say to your angry 600 million peasants when there are no jobs? And those 2 trillion dollars? You will never get the current value of them back, ever. Even if you could, it would just depress US markets even further, and you would lose as much or more in the collapse of trade. And of course, there are always currency controls. And yes, if the US wanted to it could unilaterally break the the yuan peg to the dollar and devaluate down that 2 trillion. These last two would be more last resort moves but they are available. What you are doing, Mandarin, is looking at China in isolation, a dangerous thing to do with a country with an export based economy. You are also discounting China’s problems and exaggerating its strengths. This is exactly what Wall Street did before the bursting of the housing bubble and the financial meltdown.

China as a whole is a bubble if and only if the rest of the world goes deeper into a permanent depression. I am not ready to bet on that. It’s possible to cite many negatives including a possible trade war or an outright war. Again, I am not ready to bet on these. The speculation in certain sectors of China’s economy will not be enough to undermine what is mostly a productive economy producing real goods to fill real needs – Chinese and otherwise. China is not the USA, the mentality is different, the way people work and save puts America to shame.

It’s the year of the Tiger. That cat is going to unleash it’s fury that will take down the world economy, no doubt about it. This is the resulting energy of blind market forces that cares not about humanity one iota. A new system will raise from this implosion. Expect the unexpected.

Underlying growth can cover a lot of sins, but China’s misallocation of resources is large, and it may face serious international pressure to adjust. China’s export miracle is partly productivity growth, but it also depends importantly on exchange rate undervaluation. With a sufficiently undervalued currency, a country can have an absolute advantage in everything. China is exporting many things in which it has no natural comparative advantage. The question is, how much of its productive base depends on the undervalued currency. Capacity of exporters that operate on slim margins (price close to average cost) are wasted investments. In fact, if existing estimates are right, those operating on any but double-digit margins would go out of business should currency interventions be stopped.

“Comparative Advantage” is only but a myth. It was used by the British empire to export their industrial goods abroad while keeping their colonies and the non-West as underdeveloped as possible, having them export only their raw materials and unskilled labor.

Regarding the currency issue, remember the Plaza accord?

Remember the creditor/exporter nations of the US have built up their reserves primarily as a result of consecutive US deficits. The only reason they can afford to hold onto their US dollar-denominated debt is due to this dynamic. Such a revaluation of the Dollar on a global scale could potentially undermine its reserve currency status, that is the risk here.

It is often quoted that China has historically experienced 70% efficiency in its production and manufacturing. As a command economy for a long time it has tolerated this threshold. Is what we currently see out of China now more than 30% inefficiency? After all even 2% excesses create quite a graph over 30 years.

Now that the average wage in china approaches 10% of Americans, perhaps we visualize the staggering impact of what 30% inefficiency accumulates over time. I am still puzzeled by the recent media reports of 30billion square feet of Commercial RE coming available over the next couple of years. I think Jim Chanos stated this. Thirty Billion Sq ft is enough space for a 5 foot x 5foot cube for every man woman and child in China. It probably doesn’t require much of a printing press to create the Renminbi for that activity. In terms of the natural resources, the Chinese have been harvesting Siberia for a long time. This shell game can probably continue for a couple of more years. The dam will bust at some point, but only after the dollar reserves have been declared worth-less than are now valued.

Does China now plan to hire all of us to travel to China to train our replacements?

You can deduct another analogy from Japan’s experience about China’s alleged bubble. It’s demography. Japan’s bubble economy burst when the dependency ratio (the ratio of the dependent to the productive people) hit the lowest. From then on, Japan’s dependency ratio has kept rising, which means one worker has to support more and more people. Everybody knows what has happened in Japan when the dependency ratio is rising.

United Nations estimates that China’s dependency ratio will hit the lowest around 2010, and keep rising until at least 2050. Given Japan’s analogy, China would now be indulged in the zenith of the bubble economy. We’ll see.

Having worked in western china for the last 8 years i have in the last year noticed an definite uptick in risky loans to the Ag sector at least.

20 new tomato processing factories built by independent operators with easy credit. Market is already in a glut but someone has turned on the credit spigot. Doesnt make any sense but people see Gov/Banks are printing money for any project with a shaky business plan and local admin backing.

China’s bubble won’t burst until Walmart outsource their products elsewhere. That won’t happen even with a 25% import tariff. If the US elite were serious they’d be talking 200%, in that scenario the US bubble will pop along with China.

Most countries are in a bubble these days (inflated living standards, unaffordable entitlements). The biggest bubble is the US economy, because it has the world’s reserve currency, can print the most money with the least impact on domestic inflation.

China’s is the second largest. It manages inflation by implicit price controls. For example, it can force all surplus capital into stock and real estate assets.

These being the two most powerful countries in the world, I’d look for other bubbles to pop first, despite the fact they are less severe proportionately. In this thoroughly rigged global economy, economic fundamentals matter less than political and military power.

I think China is not only an export economy- that label can better be used for a country such as Germany. Chinese economic policy has been deeply effected by the Asian-tiger recession of the late 1990s. The common belief is that they’re in the stage of bootstrapping themselves– trying to become a developed economy. For a country of China’s size no easy task.

China’s economy depends on currency manipulation. They have an export economy. If U.S. consumption recovers, China will be o.k. If the U.S. continues to falter, actions will be taken to take away China’s currency advantage. China will not be o.k. Their overcapacity and dependence will become obvious.

“Is XXX a bubble” these days should be
asked about everything, really. Trust
nothing — the dollar, the fed,
Obama, gold, China.

Imo, China should invest all the
money they can to clean up the rivers
and the water supply. After that, even if
it turns out to be a bubble, at least
they’ll have created something valuable
for future generations.

On the fixed exchange rate: the comparison with other cases is off. The reason such regimes lead to inappropriately low rates is that they are insulated from depreciation risk until some news wakes the markets up to the fragility of the peg. But in this case, it’s fragility to a devaluation, not revaluation. If I think the renminbi is going to shift up relative to the dollar, I’ll accept even lower nominal rates than what we’re seeing. The opposite is the case if I come to expect depreciation.

Jim M, I disagree about the fixed peg. Chancellor is right to point the peg out as a problem. During the boom, the peg can sometimes seem too low as the economy overheats. This was true in Latvia and in Argentina. And this is true now.

I visit China for work regularly, the building boom in all major cities is quite spectacular and obviously will end in a nasty bust. China is also heavily over invested in manufacturing capacity but they are upgrading quickly.
Infrastructure is first class in major cities.
It’s a complicated place, but no country can grow 8-10% year on year and not suffer a bubble along the way. As the banks and local governments co-operate together they will also drage each other down in speculative excess.
There is this myth that there are 100s of millions of workers who will migrate to the major cities..why? They are already bursting at the seams (too big, too expensive, not comfortable places to get around, bad pollution..these are complaints of Chinese I have met in the big cities), you need a special permit to move to large cities and the migrants may ultimately make more in their local provincial cities and towns, they cannot afford to purchase property and live in major cities. Even college graduates live hand to mouth in major cities.

There is already a migrant labour shortage on the East coast of China, their demographic screw is tightening and they are no longer the cheapest (nor should they be forever) place to make stuff.

Our company recenty tried to invest in a factory in China, but they turned us down. Yes, turned us down. A couple of years ago they would have grabbed the money out of our hands. Why turn us down? Because they were able to raise 10 million USD in a few months.

The undervalued yuan is the main reason (not only reason) that the export economy is still so strong. How long should US and other countries accept this situation?